Institutions, Markets and Financial Intermediaries: Comprehensive Course Notes
Definition and Structural Components of the Financial System
The financial system is defined as a complex ensemble dedicated to the allocation of resources and risks among operators within an economic system. This system can be examined through two distinct lenses: the structural perspective and the functional perspective. From a structural standpoint, the system is built upon four fundamental elements. First are the financial institutions, which are specialized entities that systematically provide financial services. Seconds are financial instruments, representing the formal contracts through which financial exchanges are realized. Third are financial markets, which serve as the circuit where the exchange of financial resources occurs. Finally, the system is governed by rules, an organic set of norms that discipline the activities and institutions of financial intermediation, define how exchanges are realized, dictate the functioning of markets, and establish the specific characteristics of financial instruments. These rules are established by regulators, while supervisory authorities ensure compliance to satisfy the needs of economic operators, whether they are individuals, firms, or families, exhibiting a need for financing or investment.
Functional Analysis of the Financial System
The financial system performs four primary functions essential to the economy. The intermediation function involves connecting economic operators with opposing needs, specifically units in surplus (savers) and units in deficit (borrowers), facilitating the transfer of financial resources. The monetary function is based on providing economic operators with means of payment and facilitating their circulation. The function of transmitting monetary policy impulses involves decisions regarding economic and financial variables, such as interest rates, which then reflect upon real variables, such as the unemployment rate. Finally, the risk transformation and management function offers tools to cover financial risks, often through derivatives. Banks, specifically, engage in the transformation of risks and maturities, allowing for the mitigation of credit risk for depositors while simultaneously permitting high-risk companies to obtain funding.
Circuits of Financial Intermediation and Allocation of Savings
Financial intermediation consists of transferring resources from subjects in surplus, who possess a positive financial balance () and excess purchasing power, to subjects in deficit (). This occurs through two types of circuits. In the direct circuit, units in deficit borrow funds directly from financial markets by issuing securities, known as primary securities. This circuit is not possible if there is a total divergence of preferences. In the indirect circuit, a financial intermediary systematically borrows from surplus units and uses those funds to grant loans to deficit units. Here, the intermediary issues secondary securities. The presence of an intermediary allows entrepreneurs in deficit to obtain loans while surplus operators invest and receive interest. This intermediation is termed "balance sheet interposition" because the intermediary emits financial liabilities. A primary sub-function here is the efficient allocation of savings, channeling limited resources to the most productive and meritorious investments based on the borrower's capacity to return resources in the future.
Financial Balances and Economic Sectors
Savings () represent the balance between current income and current costs, indicating non-consumed income. This can be destined for investments () in real assets. If savings are not entirely used for investment, a financial balance () is formed where . A positive financial balance leads to an increase in financial assets or a decrease in liabilities, while a negative balance requires indebtedness. Operators in surplus are those whose spending is less than total income (), thus accumulating credit against intermediaries. Operators in deficit are those whose spending on consumption and investment exceed income (), becoming net debtors. In economic modeling, households are typically surplus subjects, while the financial intermediary sector aims for an equilibrium where through the diversification of operations, as they merely channel resources rather than originating them.
Financial Instruments and Payment Services
Under the Consolidated Law on Finance (TUF), financial instruments include securities such as shares (equities), bonds (debt securities), and money market instruments like treasury bills and certificates of deposit. They also encompass units in collective investment undertakings and derivatives like options, futures, and swaps. It is critical to note that payment instruments are not considered financial instruments. Financial contracts are generally classified into debt contracts (loans and bonds), participation contracts (equities representing ownership and risk-sharing), insurance contracts (covering future uncertain events for a premium), and derivative contracts (value derived from an underlying asset). Bonds are standardized contracts equal for all investors, often featuring regular coupons and a final capital reimbursement, and are tradable on markets. Conversely, loans are personalized contracts between parties with specific conditions defined case-by-case.
Theories of Financial Intermediation and Market Imperfections
The theory of financial intermediation seeks to verify why intermediaries exist by refuting the hypothesis of perfect markets where direct exchange would be sufficient. Market failure occurs due to transaction costs, asymmetric information, and diverging preferences. Transaction costs include searching for counterparts, gathering data, legal costs, and costs related to the divisibility of instruments. Intermediaries achieve economies of scale to reduce these. Asymmetric information refers to the disparity of information between agents, leading to adverse selection (ex-ante) and moral hazard (ex-post). Adverse selection involves "bad" borrowers being more likely to seek loans, potentially driving "good" borrowers out of the market; intermediaries solve this through screening. Moral hazard occurs when borrowers use funds opportunistically after the exchange; intermediaries manage this through monitoring. Finally, intermediaries reconcile diverging preferences regarding risk, return, and duration between savers and borrowers.
Typologies of Financial Intermediaries
Intermediaries are categorized into three macro-groups. Credit intermediaries include banks, which engage in both taking deposits and granting credit, and non-bank credit intermediaries (like leasing or factoring companies) which grant loans but cannot collect savings from the public. Insurance intermediaries include insurance companies (life and non-life branches) and pension funds; they are intermediaries because they collect premiums from surplus units and invest them in financial assets until needed for claims. Securities intermediaries include Investment Firms (SIMs), Investment Banks, and Asset Management Companies (SGRs). SGRs are unique as they are authorized for both individual portfolio management and "gestione in monte" (collective management). In collective management, investors buy units of a fund, and the SGR makes investment decisions for the entire undivided pool without instructions from individual participants.
Financial Regulation and Supervision
Regulation is essential due to the systemic importance of the financial sector. There are four types of vigilance. Structural vigilance regulates the sector's structure, such as authorization norms for new banks or rules on competition. Prudential vigilance promotes sound and prudent management by establishing minimum capital requirements (linked to risk levels) and concentration limits. Informative vigilance aims to reduce asymmetries through standard accounting rules and transparency requirements. Protective vigilance intervenes to prevent crises from spreading, such as deposit insurance mechanisms (Ex-post) and inspections (Ex-ante). In Italy, the primary authorities include the Bank of Italy (stability and efficiency), CONSOB (transparency and market correctness), IVASS (insurance), COVIP (pensions), and AGCM (antitrust and competition).
The European Banking Union (UBE)
The European Banking Union was established to break the negative link between bank risk and sovereign risk and to favor financial integration. It rests on three pillars. The first is the Single Supervisory Mechanism (SSM), where the ECB directly supervises "Significant" banks (assets over euro or over of national GDP), while smaller banks are monitored by national authorities. The second pillar is the Single Resolution Mechanism (SRM), which aims for the internal rescue of banks in crisis through "Bail-in" (where shareholders and creditors, excluding depositors under euro, cover losses up to at least of liabilities). The third pillar is the Single Deposit Guarantee Scheme, intended to provide uniform protection for all European savers. Monitoring is split between microprudential vigilance (individual intermediaries, handled by EBA, EIOPA, and ESMA) and macroprudential vigilance (systemic risk, handled by the ESRB).
Specific Instruments of Credit Risk Management
Banks utilize specific procedures to manage the risk of insolvency or migration (rating downgrade). The screening process often involves an "investigation of credit" (istruttoria di fido) consisting of five phases: analyzing the applicant's personal qualities via the Central Risk Office (CR), behavior analysis, qualitative analysis (strategy), quantitative analysis (financial ratios), and synthesis/internal rating. Models range from qualitative-quantitative expert systems to automated credit scoring. In the monitoring phase, banks use restrictive clauses and relationship banking to track borrower behavior. Under the Basel Accords, credit risk is measured using either the Standardized Method (based on external ratings) or the Internal Ratings-Based (IRB) approach, where banks calculate Probability of Default (), Loss Given Default (), Exposure at Default (), and Maturity.
National and International Banking Systems
The United States banking system is characterized by a dual structure: state banks controlled by individual states and national banks controlled by the federal government (Federal Reserve). Historically, the Glass-Steagall Act of 1933 separated commercial banking from investment banking before its repeal in 1999, which allowed for Universal Banks. In Italy, banks must be organized as either Joint Stock Companies (S.p.A.) or Cooperative Societies with Limited Liability (Scarl), the latter including Popular Banks and Cooperative Credit Banks (BCC). Following 2016 reforms, BCCs must belong to a cooperative banking group (such as ICCREA or Cassa Centrale) to ensure coordination and solvency. Italian banking shifted from a model of specialization (short-term vs. medium-long term) to a model of despecialization with the 1993 Consolidated Law on Banking (TUB).
Bank Collection Operations: Deposits and Accounts
Collection operations represent a liability on the balance sheet. Direct collection includes resources acquired with a repayment obligation. The most common form is the current account (C/C), which serves a monetary function. It is a demand liability ("a vista"), meaning the client can request funds at any time. Interest is calculated using the "Hamburger method," involving the calculation of balances by value date, days between dates, and "debtor/creditor numbers" (balance multiplied by days). Other forms include savings deposits (documented by a passbook), which can be "free" or "restricted" (vincolati), and Certificates of Deposit (CDs), which are short-to-medium term debt instruments. Banks also issue bonds for medium-to-long term funding and covered bonds (obbligazioni garantite), which are backed by a separate pool of high-quality assets like mortgages.
Lending Operations: Loans and Financing
Lending satisfies the bank's investment function. Cash loans include C/C credit lines (financing working capital), pledge advances (short-term loans guaranteed by assets like securities or goods), and the discounting of trade bills (sconto). In modern practice, discounting is often replaced by "Advances on SBF Portfolio" (salvo buon fine). Factoring involves the continuous transfer of trade receivables to a factor for management, insurance, and financing. Medium-long term loans are primarily mortgages (mutuo), which involve a repayment plan (ammortamento). The Italian method features constant principal installments and decreasing interest, while the French method features constant total installments. Consumer credit ( to euro) serves personal consumption through loans or revolving credit cards.
Securitization of Credits (Cartolarizzazione)
Securitization is a technique that transforms illiquid assets, such as mortgages, into tradable securities (MBS or ABS). This process, regulated in Italy by Law 130 of 1999, involves an Originator (the bank) selling a portfolio of credits to a Special Purpose Vehicle (SPV). The SPV issues securities to investors, using the cash flow from the original credits to pay interest and principal. This allows the bank to obtain immediate liquidity, reduce liabilities, and free up capital for new investments. However, it can lead to a "shadow banking" system and reduced screening standards, as seen in the sub-prime mortgage crisis where risk was passed to investors who could not properly evaluate the underlying asset quality.
Investment and Auxiliary Bank Services
Banks offer various services that generate commission income rather than interest. Payment services include providing checks (bancario vs. circolare), bank transfers (bonifici), and debit/credit cards. Investment services, defined by the TUF and modified by the MiFID directive, include trading for own account (dealer/market maker), trading for third parties (broker), and portfolio management. Placement services for corporate clients involve helping firms issue securities; this can be without guarantee, with a guarantee of unsold portions, or through a firm purchase ("acquisto a fermo") where the bank buys the entire issue first. To manage conflict of interest, the MiFID directive requires "internal barriers" to protect the weaker party (the investor).
Risk Categories in Banking Management
Banks face several types of risk beyond credit risk. Interest rate risk arises from the mismatching of asset and liability maturities, affecting income through the "income gap" and the "duration gap." Market risk involves revenue uncertainty due to market price fluctuations in the trading portfolio. Liquidity risk occurs when a bank cannot honor repayment requests without selling assets at a loss. Exchange rate risk involves unfavorable currency fluctuations impacting the value of foreign-denominated assets or liabilities. Operational risk stems from inadequate internal processes, human error, system failures, or external events (including legal and cyber risks). Reputational risk is the negative perception by stakeholders that can lead to a decline in profits or capital. Performance is measured by Net Interest Margin, Intermediation Margin, and ratios such as ROA (Return on Assets) and ROE (Return on Equity).
The Regulatory Framework of Basel Accords
To ensure solvency, the Basel Accords establish capital adequacy rules. Basel 1 (1988) introduced a solvency ratio requiring capital to be at least of risk-weighted assets (). Basel 2 (2006) structured regulation into three pillars: minimum capital requirements (now including operational risk), the supervisory review process (ICAAP and ILAAP), and market discipline (transparency). Basel 3 (2010) focused on increasing the quality of capital, specifically "Tier 1" capital, and introduced specific liquidity ratios. Under these rules, Common Equity Tier 1 (CET 1) must be at least of , while the Total Capital Ratio () must remain above . Capital acts as a "buffer" to absorb unexpected losses, whereas expected losses () should be covered by provisions in the income statement.
Central Banking and Monetary Policy Instruments
The European Central Bank (ECB) manages monetary policy for the Eurozone with the primary goal of price stability, defined as an inflation rate of roughly over the medium term as measured by the Harmonized Index of Consumer Prices (IAPC). The ECB operates through three decision-making bodies: the Governing Council (sets rates), the Executive Board (daily operations), and the General Council. Key instruments include Open Market Operations and three official interest rates: the Main Refinancing Operations rate (cost for 1-week loans), the Marginal Lending Facility rate (cost for overnight loans), and the Deposit Facility rate (interest earned on overnight deposits). These rates create a "corridor" for market rates like Euribor (interbank rate) and (overnight rate). The ECB also uses the Mandatory Reserve requirement (currently set at ) to control liquidity.
Investment Funds and Institutional Investors
Collective Investment Undertakings (OICR) like Mutual Funds (FCI) allow savers to pool resources for professional management. Managed by an SGR, funds offer diversification, professional expertise, and lower transaction costs. Funds are classified by asset class (equity, balanced, bond, liquidity) and structure (open-end vs. closed-end). The Net Asset Value (), calculated as , determines the unit price. Cost structures include subscription fees, exit fees, management fees, and performance fees. Total shareholder cost is measured by the Total Expense Ratio (TER). Ethical funds (SRI) apply additional negative criteria (excluding certain industries like arms) and positive criteria (including firms with high ESG standards) during the selection process.
Insurance Companies and Pension Planning
Insurance companies operate by managing "pure risk" through the law of large numbers. They experience an inversion of the cost-revenue cycle, collecting premiums in advance of paying claims. They are supervised by IVASS and governed by Solvency 2, which mandates a Solvency Capital Requirement () and a Minimum Capital Requirement (). Policies are divided into "Life" (case death, case life, mixed) and "Non-Life" (damage to property or health). Pension funds provide supplementary retirement income and can be "closed" (negotiated by unions/employers) or "open" (offered by financial intermediaries). Contributions can be "defined benefit" (fixed future payout) or "defined contribution" (benefits depend on investment performance).
Questions & Discussion
Q: What is the impact of bank services on the balance sheet?
A: Most services like payment processing and investment advising do not directly impact the balance sheet assets and liabilities but appear in the income statement as commission income. Credit-related services, like loans, impact the assets.
Q: How does the ECB disincentivize banks from holding excess liquidity?
A: Through the Negative Interest Rate Policy (NIRP) applied to some periods where the deposit facility rate was negative (e.g., ), forcing banks to pay to keep money at the central bank, thereby encouraging them to lend to the real economy.
Q: What is the difference between a dealer and a broker?
A: A dealer (or market maker) trades for their own account, taking on the risk of the securities they hold to provide liquidity to the market. A broker merely acts as an intermediary for a commission, matching buyers and sellers without taking ownership of the assets.
Q: What is the significance of the 1993 TUB in Italy?
A: It moved the Italian system toward a "Universal Banking" model, allowing banks to perform a wider range of activities across different maturities, ending the forced technical specialization of the 1936 banking law.